The Valuation of Public Projects: Risks, Cost of Financing and Cost of Capital Current
20 Pages Posted: 14 Sep 2013
Date Written: September 12, 2013
It is often said that the private sector is in a good position to manage project costs and meet deadlines, but not, generally, to fund or finance projects. The underlying argument runs as follows: because the interest rate on government borrowings (the government’s financing cost) is lower than what is available to the private sector, the cost of goods or services will necessarily be lower if it is funded by government. However, there is confusion between the cost of financing and the cost of capital (or discount rate) that stems from an analytical error in assessing the true cost of public funds. This is a subtle but important error that is widespread in both the public and private sectors as well as in academia.
This analytical illusion is due to the fact that a significant portion of the government’s cost of capital is unaccounted for or not recognized. This portion is the implicit option granted by taxpayers to their government to require additional funds in order to meet the commitments made to the lenders when a project does not meet the expected level of profitability.
Discounting at an essentially risk-free rate is often justified by “the virtually unlimited taxing power of the Crown” – the project appears risk-free to lenders, but is obviously not risk-free for taxpaying citizens.
The authors identify the implications for the evaluation of public investments and relevant public policies such as direct subsidies to businesses, government endorsements of corporate borrowings, the comparison of public sector versus private sector delivery of public projects and holding a portfolio of risky investments dedicated to the future repayment of the debt. It goes without saying that other evaluations of government policies and interventions could be similarly challenged.
Keywords: Governance and Public Institutions, Pensions, Infrastructure
JEL Classification: H43, H54, H81
Suggested Citation: Suggested Citation